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Is The U.S. Oil Patch A Value Trap?

Oil

While the S&P 500 is up 6.49 percent, year to date (YTD), it has not brought any cheers to energy investors. Energy investors continue to see their investment bleed, as the energy sector is down 10.02 percent YTD. For the others waiting on the sidelines, the big question is whether to enter at the current levels or stay away from the energy stocks altogether.

Let’s solve this puzzle!

We analyze the investment rationale for the short-term investors who have an investment horizon of less than a year and for the medium-term investors, who have an investment horizon of about 1-2 years. The long-term picture is too uncertain; hence, we won’t delve into it.

The short-term picture

In the short-term, the equity market is dictated more by sentiment, rather than the prevailing fundamentals.

After the Organization of the Petroleum Exporting Countries (OPEC) – excluding Nigeria and Libya – and 11 non-OPEC nations arrived at a deal to cut oil production by 1.8 million barrels per day (bpd), traders expected oil to at least reach $60 per barrel levels. However, repeated failure to cross above $55 per barrel in the last four months has kept the sentiment in oil bearish.

Why couldn’t oil rally higher?

OPEC has surprised the analysts by their high level of compliance. However, the US shale oil producers have used the rise of oil to $50-per-barrel levels to resume drilling activity at a frantic pace. In the latest report by Baker Hughes dated April 28, 2017, the oil rig count reached 697, a huge increase from the lows of 316 in May 2016.

This has correspondingly seen the US crude oil production rise to 9.265 million bpd, a huge rise from 8.428 million bpd in July 2016. While the US Energy Information Administration expects the US crude oil production to increase about 29,000 bpd this year and 57,000 bpd next year, Rystad Energy believes that the growth will be 100,000 bpd each month for rest of this year and into 2018, if oil prices sustain the $50-$55 per barrel levels, reports Reuters. Related: Trump Flirting With The Idea Of A Federal Gasoline Tax Increase

Along with the US, Libya—which is exempt from the production cuts—has resumed operations at its Sharara and El Feel oilfields, which will add another 400,000 bpd of oil to the markets.

Hence, the US inventory levels are reducing at a much slower pace than expected. The EIA reports: “At 528.7 million barrels, U.S. crude oil inventories are near the upper limit of the average range for this time of year.”

Therefore, in the short-term, the oil price rally appears to be capped at $55 per barrel level. Though OPEC is most likely to extend their deal through the second half of the year, it will only be a temporary booster. Any material rally in oil will only be possible once US inventory levels drop below the 5-year average. If, therefore, one wants to buy from a short-term perspective, the energy sector might not outperform the S&P 500.

Now, let’s see the prospects of the sector in the medium-term.

The medium-term picture

(Click to enlarge)

Consistent low oil prices have led the oil companies to slash their budgets. As a result, in 2016, only 2.4 billion barrels of oil was discovered, against an average of 9 billion barrels per year, over the past 15 years, said the IEA.

The report also said that “the volume of conventional resources sanctioned for development last year fell to 4.7 billion barrels, 30% lower than the previous year as the number of projects that received a final investment decision dropped to the lowest level since the 1940s.”

Such low level of oil investment, for the third year in succession in the wake of rising global demand can lead to a supply crunch in the future. Related: Russia Inclined To Extend Output Cut Deal With OPEC

Every new piece of evidence points to a two-speed oil market, with new activity at a historic low on the conventional side contrasted by remarkable growth in US shale production,” said Dr. Fatih Birol, the IEA’s executive director. “The key question for the future of the oil market is for how long can a surge in US shale supplies make up for the slow pace of growth elsewhere in the oil sector.”

In its latest Short-Term Energy Outlook, the EIA forecasts WTI crude oil prices to average $52 per barrel in 2017 and $55 per barrel in 2018. The World Bank, on the other hand, is more bullish and has forecast crude oil prices of $55 per barrel in 2017 and $60 per barrel in 2018.

Waghorn, the manager of the Guinness Atkinson Global Energy Fund notes that in the past few months, energy stocks are falling, while oil has been in a gradual uptrend. In the past few decades, this has happened only thrice – January 1999, October 1987, and April 1986 – and every time, the energy stocks have outperformed the market substantially in the following six months to two-year period.

Thus, with a 1-3-year horizon, the energy sector looks good for investment. However, investors should do their due diligence in picking the stocks with good fundamentals instead of going after low priced stocks.

By Rakesh Upadhyay for Oilprice.com

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